In this episode, I discuss the effect of stock options or stock-based compensation expense on the after-tax returns of shareholders. These expenses paid to executives as compensation are often excluded from expenses when non-GAAP earnings are reported.

An approximate transcript is shown below:

Hello and welcome to Episode 3 of the DIY Investing Podcast. My name is Trey Henninger and I’m your host. Today’s episode we will be focused on fundamental analysis, one of the key tools that value investors have when valuing a company for potential investment. In particular, we will be doing a deep dive on Stock-based compensation expense. This is also known as equity compensation, stock options, or share-based executive compensation.

The outline for today’s show will be as follows:

First, I’ll give a little bit of background into the history of stock based compensation expense, where they are used and how the accounting works.

Second, I’ll discuss how Stock based compensation is accounted for in U.S. GAAP accounting, international accounting, and U.S. Non-GAAP earnings.

Third, we’ll discuss some examples of companies which abuse non-GAAP earnings to pretend that stock based compensation expense is in fact NOT an expense.

Finally, we’ll summarize what we’ve learned and provide some actionable advice for you to use in your fundamental analysis.

Let’s begin with the background of Stock Based Compensation

Before the 1900s, most companies were managed and run by their owners. Either as a family business, or at least overseen by the major shareholder. However, beginning in the early 1900s, professional company managers arose which began to run businesses without being a major owner of the business. They might own little to no shares in the underlying company which they were managing as CEO.

Therefore, the idea of stock-based compensation arose. Initially in the form of options, company managers were granted the ability to buy stock in the company, and have an equity stake. This gave them an incentive to work for the long-term benefit of the company’s owners. Precisely because they were now themselves an owner in the company. (An aside: Never forget the power of incentives. It’s one of the most impactful mental models.)

By the 1950’s stock options were growing in popularity, and were starting to be used as a key component of long-term incentive programs. In the 1960’s, a new form of stock based compensation was created in the form of restricted stock. Restricted stock then gained popularity from the 60s through to the 80s, because the stock market was in a secular bear market. Stock options only have value if stock prices are increasing, so they needed a form of compensation that wasn’t restricted to increasing stock prices.

However, by the 1990s, stock options became all the rage. Stock options were a key component by which tech companies or tech start-ups would compensate employees in silicon valley. Stock options were essentially a ticket to becoming an instant millionaire if your company could successfully IPO at a high price.

There was one big kicker though: When a company paid their employees or executives with stock options or restricted stock in the 1990s, they didn’t have to report that payment as an expense on their income statements. This way, a company could be continuously diluting the other shareholders of the company by issuing massive amounts of stock, but could hide the fact that this was impacting the long-term profitability of the company from the perspective of the other shareholders.

As we all know, the stock market crashed in 2000, leading to some diminished use of stock options in the early 2000s as the markets reached a low.

Then, in 2005, the rules changed. Now, companies had to report stock based compensation as an expense on their annual income statements that they released to the public. All of a sudden, a massive light was shined upon this practice of covering up real expenses.

That leads us into the second section of our podcast:

We need to discuss how Stock based compensation is accounted for in U.S. GAAP accounting, international accounting, and U.S. Non-GAAP earnings.

Let’s begin with some terminology, because you need to understand these details.

Meanwhile, the international version of this is the IFRS or International Financial Reporting Standards.

The third type of reported earnings are U.S. based earnings that are “non-GAAP” which essentially that they are NOT based upon quote “generally accepted accounting principals.”

That should be a major red flag for you there.Why would companies want to report earnings that aren’t based upon what’s generally accepted? The answer, like most things is complicated, as there are some legitimate uses for non-GAAP accounting, so that management can give shareholders a greater insight into the true underlying earnings capability of a company.

However, not every management is so altruistic. It’s become quite common to use non-GAAP to report earnings which are essentially fake to shareholders, and then publicize this as a success.

One of the key areas where this occurs is in Stock-Based compensation. As you’ll see though, not even the U.S. GAAP standards are perfect. Let’s look at a comparison between how US GAAP standards and the International FInancial Reporting Standards compare when discussing stock based compensation in employee share purchase plans. I’m going to quote an RSM White Paper on the differences between these two accounting measures.

A major difference between U.S. GAAP accounting and IFRS accounting is that: “All employee share purchase plans are considered compensatory and within the scope of the share-based payment guidance.” by IFRS, while under GAAP, “An employee share purchase plan that meets certain criteria is not considered compensatory.”(compensation)

So, as you can see, even GAAP accounting fails to properly equate stock based compensation as an expense in all categories. However, it is much better than non-GAAP accounting in this area.

To quote a PWC white paper on stock based compensation. PWC is a major accounting firm. This quote skips some words and sentences which are not useful for our current discussion. Such as citing the specific standard numbers it’s applicable to.

“A company’s management may use a non-GAAP financial measure that excludes the effect of stock-based compensation?. the discussion of a company’s performance should address significant trends, variability of earnings, and changes in significant components of revenues and expenses. Given the differences between stock-based compensation and other expenses, management should determine if investors would be well served by including transparent disclosure … of the amount of expense associated with stock-based compensation awards and the reasons why such amounts fluctuated from period-to-period.”

As you can see, companies are certainly allowed to present non-GAAP accounting, but they need to make sure that by doing so, it is done in the interest of serving investors well. I’m not convinced that is the case for all companies when it comes to stock-based compensation.

That brings us to our third section:

Examples of Companies which abuse Stock Based Compensation to mis-represent their earnings capacity to investors.

I’ve got 3 examples for you today.

First, let’s discuss Twitter. Everyone has heard of Twitter, they’re massive. Let’s look at their most recent quarterlyearnings pressrelease dated April 26th, 2017. They report first quarter 2017 non-GAAP positive earnings of $82 million, or $0.11 per share. However, since they’re required to also report earnings based upon GAAP, they report a loss of $62 million or negative $0.09 per share. That’s a huge difference. $144 million in difference. If you go based upon the company’s preferred metric, they’re making a profit. But, if you actually use accepted accounting principles, they’re losing millions of dollars each quarter.

They also report that they expect stock-based compensation to be approximately $120 million in the second quarter of 2017. If we make the assumption that this was the same cost in the first quarter, then stock based compensation makes up 83% of the 144 million dollar difference between their two reported figures. This is staggering.

Second example: Salesforce.com

In their most recent earnings press release dated February 28th, 2017, they report earnings for fiscal 4Q 2017, of $0.28 per share on a non-GAAP basis, but a loss of $0.07 per share on a GAAP basis. They then predict that for their next quarter to have a stock-based compensation expense of $0.32 per share. This is again almost the entire difference between their supposed profit, and their actual losses.

Third example: Workday Inc.

In their most recent earningspress releasedated February 27th, 2017, they report earnings for full year earnings for fiscal year, of positive $0.12 per share on a non-GAAP basis, but a loss of $2.06 per share on a GAAP basis. They report that they had share-based compensation of 378 million dollars last year. How can they possibly behave like that’s not a real expense.

I’m sure the employees certainly consider it real compensation.

This examples illustrate a trend which is especially concerning. Stock prices in the stock market are already at highs which mirror the DotCom bubble of the late 1990s. In addition, we’re once again seeing the trend of tech companies using stock-based compensation to hide the fact that they don’t make any money. Don’t let this fool you.

Let’s conclude by highlighting two companies which used to misrepresent their earnings by claiming that stock-based compensation was not an expense, but who now admit that it is.

In particular, we’re talking about Facebook and Amazon, two of the largest tech companies today. This quote comes from an article on Investors.com titled Amazon, Facebook Admit Stock Compensation Is A Normal Cost.

“For more than a decade, technology companies doled out heaps of stock to recruit top talent — then pretended this wasn’t a normal part of doing business by reporting profit numbers that subtracted the cost. That’s changing as the industry grows up and responds to pressure from regulators and investors.Amazon.com (AMZN) started breaking out stock-based compensation in the results of its different businesses in the first quarter. This is “the way we now evaluate our business performance and manage our operations,” Chief Financial Officer Brian Olsavsky told analysts after the earnings report last week.Facebook (FB) Chief Financial Officer David Wehner had a similar message. From now on, he said he’ll talk about the social network’s results and other metrics based on U.S. standards known as Generally Accepted Accounting Principles, or GAAP, which include equity-based pay costs, instead of a mix of GAAP and non-GAAP numbers. “We view it as a real expense,” he said.”

Now, why are Facebook and Amazon changing this practice now? It’s because they have actually started to make real profits. Real, honest, true profits that don’t require this sort of manipulation of profits.

I want to end on a quote from the 1998 Berkshire Hathaway shareholder letter by Warren Buffett.

A few years ago we asked three questions to which we have not yet received an answer:“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

So, In summary

Stock based compensation is most definitely a real expense from the perspective of a shareholder. As a value investor it is your job to investigate the numbers that a company reports for any manipulation of earnings which could hide the real earnings capability of the company. Stock-based compensation, in all of it’s forms, is one of the key areas that you should focus on.

If a company is paying it’s employees in stock, then more shares will exist at the end of the year, which means all future profits of the company will be split amongst more shares. This is BAD for you as a shareholder. In this situation, you are automatically being diluted in your ownership position of the company.

At a minimum, if a company is paying their employees or executives with share-based compensation, you want them to be repurchasing shares each year to offset this dilution. This practice, at least forces a company to recognize that paying employees in stock, is a real expense.

Ideally, you’d only own companies that refuse to compensate their employees or executives with stock based compensation. Unfortunately, companies like that are rare, and if you want to own the best companies in the world, you’ll have to take stock-based compensation into account. Just make sure that you aren’t fooled by any management who argues that stock based compensation is not a true expense.

Your action step for today: Pull up the most recent earnings reports by the companies that you own. Check to see what they say either about share-based compensation, or check to see if there is a large gap between reported non-GAAP earnings and GAAP earnings. Take it as a major red flag if you see such a gap, and assess whether you should still own that company.

Thank you for listening to today’s podcast. If you liked this content and found it valuable, please subscribe.

If you’d like to find the show notes, you can find them atdiyinvesting.org/epsiode3.

Thank you once again for listening to the DIY Investing Podcast. I appreciate your support.

About Trey Henninger

I am an engineer, private investor, and business owner. I want to empower you, and to help you unlock the potential future earnings which would go to waste if you ignore investing any longer. I taught myself how to invest and now I hope to help teach you how to invest. I am not a world renowned investor and I haven’t yet become rich off of investing. However, I have spent thousands of hours reading, learning and teaching myself how to invest. I hope you’ll join me on my own journey of becoming the best investors we can.

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